Every type of financial marketplace relies heavily on bid and ask rates. What are these terms and how do they relate to forex spreads and trading?
Basics of Bid and Ask Rates
A bid is the highest price a buyer is willing to pay for an asset in a trade. Asks, or offers, are the lowest prices the seller is willing to accept for a given asset. Spreads are the differences between ask and bid prices. Ask prices are typically higher than bid prices. Spreads narrow as an asset becomes more stable (and liquid).
Global financial markets require traders to use brokers, banks, or another large financial institution to host their transactions. Spreads represent a trade’s execution cost.
The basics of Forex spreads
Spreads in forex are determined by the difference between the bid and ask price of a currency. While we normally think of an exchange as a reciprocal transaction, this definition is somewhat misleading in the case of currencies. In the same way that any other commodity is bought and sold for a specific price, currency is no different. When one currency is sold and another is purchased, the exchange process actually involves two separate transactions.
Banks, brokers, and financial institutions ultimately determine the exchange rate, even if global market conditions have a significant influence. Because the host controls the price of the asset (and therefore, its liquidity), they are known as the “market maker.” Brokers and other hosting businesses can set different spreads for their currencies.
Forex spreads: what are they?
Forex spreads can be fixed or variable. Due to constantly changing factors such as trading activity, supply, and shortages, a variable (floating spread) fluctuates between the ask and bid prices.
Alternatively, fixed forex spreads let market participants identify the spread cost before buying, which allows them to develop short-term or long-term strategies. As a result, prices are more transparent and cost assessments are more accurate.
What is the impact of market volatility and time of day on forex spreads?
There is usually high volatility and low liquidity if there is a wide spread between bid and ask prices. The spread is large when there is little activity in the market and a low trade volume.
Conversely, a low spread likely means there’s high liquidity and low volatility, which occurs when the market is active and there’s a lot of activity or a high number of contracts that are being traded.
Forex spreads are also affected by the time of day. Trading on European markets begins as early as 3 am EST in the U.S., while trading on Asian markets continues into the night for both European and U.S. traders. The forex spread will be considerably higher for European trades initiated during Asian market hours than for European trades initiated during European trading hours.
A currency’s liquidity will be reduced if it is not in its normal trading session, because fewer traders will be involved.
How do you define a high spread?
Typically, a high spread occurs when there is a large gap between the bid price and the ask price. In general, a higher spread means that the market is volatile or that liquidity is low due to trading outside of market hours.
A simple method for calculating spreads
Having a good understanding of spreads is a valuable skill that goes beyond forex trading. When you travel abroad, understanding a hotel or airport kiosk’s spread before choosing a host for currency exchange is important.
Consider the scenario of exchanging U.S. dollars for euros. Currently, your hotel’s exchange rate is EUR 1 = USD 1.4 (bid)/USD 1.5 (ask). This means its asking price is $1.5 per euro. In other words, if you wanted to buy €1,000, you would have to pay $1,500 (1,000 x 1.5).
It may be that you will want to return the €1,000 to the hotel in exchange for U.S. dollars later. If you sold the hotel euros at USD 1.4, you would receive $1,400 as a return. In this case, the market maker pockets the $100 difference from the two transactions as spread (in this instance, the hotel). It makes a small profit on every transaction it hosts because its ask price is slightly higher than the bid price. Foreign exchange markets operate on the same principle when it comes to buying and selling currencies.
As a result of this example, another financial institution-such as an international bank-is likely to host the transaction, making it the second party to the trade. To minimize risk and cover costs, it will offer to its customers a much higher spread than the market price.
Indirect vs. Direct Currency Quotes
Direct or indirect price quotes can be used to express the price of a currency pair in forex.
In a direct price quote, the foreign currency exchange rate is expressed in terms of the domestic currency you have in your possession. A direct quote for USD to GBP, for example, might be 1.1430 if your domestic currency is USD. Because USD is the base currency, it would be expressed first (as a ratio of USD/GBP). In this quote, USD 1 equals GBP 1.1430, putting the base currency (USD) first.
Compared to direct price quotes, indirect price quotes are the exact opposite. They show the exchange rate between your domestic currency and foreign currency. For example, an indirect quote would express GBP/USD rather than USD/GBP. As an indirect price quote, the same direct price quote above would be 0.8748, which means that GBP 1 would be equal to USD 0.8748, or roughly 87 cents.
Direct price quotes typically reflect USD/foreign currency’s value, with USD serving as the base currency. By understanding how direct quotes can be converted to indirect quotes-and vice versa-you can determine the spread and compare your options more easily.
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